TRANSPORTS CONTINUE TO LAG BEHIND THE DOW INDUSTRIALS WHICH IS A DOW THEORY WARNING -- THE FACT THAT UTILITIES ARE THE STRONGEST OF THE THREE DOW AVERAGES MAY BE ANOTHER WARNING
TRADITIONAL DOW THEORY DIVERGENCE...I was asked during an interview on Stockcharts TV yesterday whether I was concerned about the Dow Theory divergence between the Dow Industrials and the Dow Transports. I responded that I was. But with an additional twist to that theory which is also giving a warning signal. But let's start with the more traditional relationship first. Chart 1 compares the Dow Industrials (black bars) and the Dow Transports (red bars) over the last year. The black circle in Chart 1 shows the Dow Industrials rising above last year's high during July to reach a new record. The red bars, however, show the Dow Transports trading well below their 2018 high. In fact, the declining red trendline shows that the transports peaked last September, and have been forming a pattern of "lower peaks" since then. The Dow Theory holds that an upside breakout by the Dow Industrials needs to be confirmed by a similar breakout in the transports. The fact that the transports have lagged so far behind the industrials is not a good sign for the market. That's because the more economically-sensitive transportation stocks have a history of turning down first in the late stages of a bull market. But the third Dow Average may also be giving a warning.
THE DOW UTILITIES ARE THE STRONGEST OF THE THREE...The Dow Jones Utility Average didn't exist at the start of the last century when Charles Dow first formulated his theory between the industrials and transports (which was intended to be used as a leading indicator of the economy). If it did, I suspect he would have included it in some fashion. That's because the relationship between the utilities and the two other Dow Averages also tells us something about the strength of the stock market. And right now the utilities are also giving a warning signal. The next chart shows what that warning is.
Chart 2 compares the trend of the Dow Utilities (upper box) to the Dow Industrials (lower box) over the last year. It's clear that utilities have been much stronger. The green circle in the upper box shows the Dow Utilities hitting a new record high during March, which was four months before the Dow Industrials accomplished that (black circle). And the utilities uptrend has been much stronger. Over the past twelve months, the utilities have gained more than 13%; while the industrials have risen only 3%. Here's why that's a problem. Utilities are traditionally considered to be a defensive sector. As a result, they tend to lag behind the industrials (and transports) in strong market uptrends. Right now, they're the strongest of the three. That's very unusual in a rising market. A study of previous market tops (2007 and 2000) show that transports tend be the weakest of the three in the late stages of a bull market. While utilities start do better as investors start rotating into more defensive sectors. Like what's been happening this year.
To make matters even more concerning, the Dow Transports lost -7% over the past year which makes them the weakest of the three. The combination of utilities strength and transportation weakness has also happened in the late stages of previous bull markets.
A STUDY OF THE PAST PEAKS...Chart 3 plots a relative strength ratio of the Dow Transports divided by the Dow Utilities over the last twenty years (since 1999). The first four red trendlines highlight previous downturns in that ratio. And shows each of them preceding (or coinciding with) market declines during 2000, between 2007-2008, 2011, and 2015. The last falling red trendline shows the decline in their relationship over the last year, which is the biggest drop in three years.
Chart 4 plots a ratio of the Dow Transports to the Dow Industrials over the same twenty years. The red trendlines show previous ratio downturns preceding 2000, 2007, 2011, and 2015 market declines. [Stock indexes dropped nearly -20% during 2011]. The most striking part of Chart 3, however, is that the ratio has been dropping since 2015, and shows the biggest divergence between the Dow Industrials and Transports in the last two decades (see rising trendline). That would be enough to keep Mr. Dow up at night.
HISTORY OF DOW UTILITY/INDUSTRIALS RATIO...Chart 5 plots a relative strength ratio of the Dow Utilities divided by the Dow Industrials over the last five years. The solid gray area shows the Dow Industrials. As a rule, the ratio usually declines when the Dow is strong; and rises during periods of stock weakness. The chart shows the ratio spiking higher during 2015 during that year's volatility (caused largely by a Chinese devaluation of the yuan that August). The ratio turned back down during 2016 as stocks resumed their uptrend. The ratio bottomed again at the start of 2018 when trade tensions began and stocks weakened. The ratio spiked again during the second half of last year when stocks suffered an even bigger downturn (see circles). The rising ratio during the fourth quarter reflected defensive money rotating into Treasury bonds for safety, along with bond proxies like utilities.
The Dow has recovered strongly during 2019 and reached a new record during July (before pulling back during August). It's still up 13% for the year. What I find concerning, however, is that the utilities/industrial ratio kept climbing all year despite the stock rally. That means that utilities have risen faster than industrials this year. That's unusual in a rising market. The chart also shows the utilities/industrials ratio rising above a falling trendline extending back to 2016 when the last upleg of the ten-year bull market began. That may be suggesting a shift in their relationship in favor of defensive utility stocks. That wouldn't be a good sign.
Historically, utilities have been considered to be "late cycle" winners. Along with consumer staples and real estate. Plunging bond yields have been driving those dividend-paying stocks to record highs this year and making them market leaders. [REITs and utilities have been the strongest performers during this week's stock selloff]. Those bond proxies account for three of the five sectors hitting new records this year (along with cyclicals and technology). That's not exactly a vote of confidence in the stock market. Neither is the plunge in bond yields that's pushing bond proxies like utilities to new records in a search for higher yields. And maybe some safety in the face of a slowing global economy. [Please see Dow Theory footnote below Chart 5].
DOW THEORY FOOTNOTE...Charles Dow started comparing the two Dow Averages he helped create at the Wall Street Journal around the start of the last century. Although chartists compare the two original Dow Averages to gauge the strength of the stock market, Dow actually used them to help predict turns in the economy. Industrial companies made the products; while transportation companies (mainly railroads) transported them to markets. Both needed to function right to keep the economy going. He may have been the first person to use the direction of the stock market to gauge the strength of the U.S. economy. I find that to be a much bigger contribution to technical analysis than the Dow Averages themselves. The Dow Jones Utility Average was created in 1929 several years after his death. I hope he would have approved of my interpretation of it. And my insertion of it into his original Dow Theory.
